All Is Not Rite With This Company

While researching Walgreen (NYS: WAG) as a possible outperform CAPScall, I couldn't help but notice that competitor Rite Aid (NYS: RAD) makes a much more attractive underperform pick. This is a company that has not had a profitable quarter in half a decade. Debt is mounting, and the book value of assets is dwindling. Read on to see why I believe a Rite Aid recovery will be slow and painful -- if shareholders are lucky enough to have one at all.

Much of the increase in sales was because of Rite Aid's pharmacy segment, which contributes 68% of sales. Not long ago, the Rite Aid in my own town had a giant banner out front, proclaiming, "Welcome Walgreen Customers!" referencing how Rite Aid had lucked out after a falling-out between Walgreen and pharmacy benefits manager Express Scripts (NAS: ESRX) sent customers searching for a new pharmacy.

All those new customers have apparently also joined Rite Aid's Wellness+ customer loyalty program, giving them sale prices to incentivize them to shop more, and giving Rite Aid more access to precious customer spending data. The number of active members is up 16% over last year, an encouraging number for shareholders.

Health and beauty aids on a pigUnfortunately, most of the 11% jump in sales in the fourth quarter came from the mercy of a calendar. The quarter had an extra week in it. Without that extra week, sales would only have increased 3%, a far less rosy comparison. Gross profit margin in the fourth quarter also fell 141 basis points, eroding the little good an increase in sales did.

Ironically, gross margin may have fallen in part because of the extra Wellness+ members. Change to Win Investment Group, or CtW, an investment group that works with pension funds sponsored by unions, including Rite Aid's own workers' union, recently issued an open letter calling on the company to disclose more details about the actual cost of Wellness+.

Based on company data, CtW found that sales per Wellness+ member have fallen more than 40% since the program's introduction, suggesting that the majority of the new members are the kind who sign up just to get a one-time deal. In fact, 46% of Wellness+ members have only used their card once or not at all in the past six months. What's worse, the program is intended in part to drive more customers to the pharmacy, the core of Rite Aid's business. But at a recent conference, management bluntly admitted that they "haven't driven a significant amount of additional foot traffic with [Wellness+] on the pharmacy side."

CtW isn't the only group sending Rite Aid angry letters. Two U.S. senators recently expressed concern over Rite Aid's "wellness ambassadors," essentially normal sales clerks dressed in white pharmacist coats. While the company insists the wellness ambassadors aren't giving out any inappropriate product advice or recommendations, this still seems like a worse marketing idea than the company's "With us, it's personal" slogan, which sounds more like the tag line to a revenge movie.

The Foolish bottom lineAs Shubh points out, Rite Aid has suffered 19 consecutive quarters of losses. It has a precarious interest coverage ratio, and barely enough cash on the books to pay another quarter's worth of interest, forcing the company to barely scrape by.

Some have speculated that Rite Aid might at least be a buyout candidate, whether by top competitors Walgreen or CVS Caremark (NYS: CVS) , or even Wal-Mart (NYS: WMT) . I see this as unlikely. Wal-Mart has been more interested in emerging markets acquisitions lately, and with an enterprise value of $7.66 billion, most of which is debt, Rite Aid would significantly inflate its competitors' balance sheets -- the same mistake Rite Aid itself made several years ago. Rite Aid may be able to keep limping along, but I'm confident it will at least underperform the market for a while yet.